Equity mutual funds are ideal for those who want to participate in the rally of the equity markets, and are wary about direct stock purchases. However, when it comes to equity funds, investors often get confused about the objectives of the various categories of equity mutual funds. If you want to make a prudent investment choice, here is all you need to know about equity funds.

What are Equity Funds?

An equity fund is a mutual fund scheme that essentially buys ownership of various businesses that are traded publicly. This is done by investing the pool of investors’ money in stocks of these businesses. The objective of all equity funds is to seek out opportunities to invest in a business that will grow thus yielding profits for its shareholders.

Types of equity funds

There are different types of equity funds, categorized according to risk levels. The most popular ones are as follows:

Fund Type

Risk

Investment Portfolio

Diversified Equity Fund

No concentrated risk.

Investments are made in equities across various sectors, so risks are well spread out.

ELSS (Equity Linked Savings Scheme)

A little riskier than equity diversified funds as their portfolios are expected to outperform over a longer time frame.

These funds invest across all sectors, thereby diversifying risks and giving investors the twin benefits of capital gains and tax savings.

Index Funds

The risks are similar to a benchmark index.

The portfolio composition is in the same proportion as the index it is based upon.

Sectoral Funds

High risk, as there is concentration on a handful of sectors.

Actively managed, the entire corpus of the fund is spread across one to three sectors.

Thematic Funds

High risk as investments are made on themes such as infrastructure, energy, rural India and the likes.

These funds carry a high risk as they are based on the perceptions and conviction of the fund house and the fund manager.

Classification of equity funds on market capitalization

Apart from the classification based on risk, equity mutual funds are also categorized according to market capitalization. Market capitalization means the total valuation of the company based on its current share price and number of outstanding stocks. Therefore, there are large cap funds that invest in the best known blue chip / highly liquid stocks, mid cap funds that invest in companies that have potential to grow into large companies and small cap funds that invest largely into small cap stocks that have some good fundamentals.

In most of these funds, an investor can select either the growth or the dividend option.

In the growth option, the investor does not receive any payments in terms of bonuses or dividends. All returns can be reaped only after selling off the units.

Under the dividend option, an investor receives payouts at periodic intervals, though neither the dividend amounts nor the intervals are certain.

In the case of equity mutual funds, however, it is best to choose the growth option, so as to make the power of compounding work for you as equity funds should be chosen for a long-term horizon.

Pros and Cons of investing in equity mutual funds

The eternal conflict that retail investors face is whether to buy equity mutual funds or individual stocks. If you are facing the same dilemma, weigh the pros and cons of taking the mutual fund route to equities.

Pros:

Professionally managed:

If you find it difficult to answer questions like what is a good stock to pick and when is a good time to buy or sell, you can rely on the expertise of fund managers with equity mutual funds.

Diversification:

You may not have the cash to buy a large number of stocks of varied companies. Investing in an equity mutual fund gives you that opportunity while offsetting the risk factor with diversification.

Choice of funds:

You get the flexibility to choose the type of equity fund depending upon your risk appetite.

Liquidity:

Apart from ELSS or close ended funds that have a lock-in period, mutual fund units are highly liquid and can be sold whenever you need to encash your investments.

Cons:

You cannot choose your own stocks:

You may want a particular share to be in your portfolio, but you do not have a say in the stock selection of the fund manager.

Fees and other expenses:

For the services they provide, mutual funds charge you management fees and expenses. These are however, capped under regulations.

Factors to keep in mind when choosing an equity fund

While investing in equity funds the golden rule is to try and diversify as much. This way you can reduce the risks and get maximum capital appreciation and tax benefits.

The other factor to keep in mind is the pedigree of the fund house and how it has performed in a downturn. You can evaluate the long-term returns that its funds have provided.

Needless to say, your investments should be aligned to your long-term financial goals.

Conclusion

Equity mutual funds are certainly less risky than investing directly in the stock markets and come with a host of benefits. While investing in equity funds, the aim should be to invest systematically over a long period of time. Investments in equities should be made to meet your long-term financial goals, so invest prudently in funds that provide stability to your portfolio.